Examining “Real Alpha” and “Exotic Beta” in mutual funds

nicheWith the explosion of hunters searching for the same scarce alpha and the proliferation of high-frequency trading, is asset management still all about alpha?  Yes, says Jane Li, CAIA, of  FundQuest, a division of BNP Paribas.  Her research of over 10,000 mutual funds (both alive and dead) collectively managing $4  trillion shows that it depends on which category of fund you’re talking about.

liSpecial to AllAboutAlpha.com by: Jane Li, CFA, CAIA, Manager, Investment Management & Research Team, FundQuest

Many argue that more efficient financial markets permanently reduce the potential for managers to produce bona fide alpha.  For example, the author of “Illegal Alpha,” published on AllAboutAlpha.com in November suggested that

“…nowadays talk of alpha generation and alpha-beta separation still permeates, though the search for it – and expectations of finding it – has greatly diminished.”

I disagree.  In fact, following the significant out-performance of many active managers over their passive peers in 2009, it seems logical that investors will rekindle their passion for searching for alpha.

The most important criterion for choosing between a passive or active product is whether active managers are able to add value by generating real alpha. Real alpha is the additional return truly stemming from the unique ability and skill set of the investment manager.

In early 2009, I authored the FundQuest study, What Now?Active or Passive Management? Examining Real Alpha and Exotic Beta. The study analyzed 30,435 U.S.-domiciled non-index mutual funds in 60 categories representing almost $4 trillion of US and non-US assets as of the end of 2008.  It included all live and obsolete mutual funds in the Morningstar database to minimize survivorship bias. Mutual funds were analyzed for the 15-year period from January 1, 1994 to December 31, 2008. Each fund’s behavior pattern and performance was analyzed for 13 rolling 3-year trailing periods ending December 31, 2008.

The study’s main conclusion was that we should not paint either active or passive investments with a broad stroke, as both types of investments have their strengths and weakness.

Importantly, there is very wide variation in the relative performance of either active or passive management from one style category to another. In some style categories, a high proportion of active managers consistently beat index-based investments while in others, very few active managers justified the additional management expenses.

The study also analyzed mutual fund performance patterns in different market environments. The 15-year period was divided into two groups based on market conditions: the bull markets of 1994-1999 and 2003-2007, and the bear markets of 2000-2002 and 2008. The asset-weighted average exotic beta and real alpha of each category for each market condition was also calculated.

Generally, active managers generated more real alpha in bull markets and lower real alpha in bear markets. In aggregate bull markets, the real alpha generated by the entire universe was 0.44 higher than that in bear markets. Specifically, 38 out of 60 categories generated more real alpha in bull markets, while 24 out of 60 categories held relative strength in bear markets. Many growth categories performed better in bull markets, while some value categories generated more real alpha in bear markets. Details are provided in the following chart. As shown below, eight categories generated positive real alpha (>0.5) in both bull and bear markets.


In all, 19 categories of funds generated positive real alpha in bull markets and 12 categories generated positive real alpha in bear markets.ranks

It appears from these findings that active management (in the form of mutual funds in this study) still produces alpha – particularly in niche strategies that may rely more on exploiting informational inefficiencies.  While the “expectations of finding alpha” may be somewhat “diminished,” the reality appears to be that alpha continues to exist.

We’ll see if this hypothesis holds up.  Our next study will be published in the first half of 2010.

– Jane Li, January 2010

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  1. Michael W.A. Kaal, CAIA
    February 5, 2010 at 10:40 am

    Reading ‘Examining “Real Alpha” and “Exotic Beta” in mutual funds’ on allaboutalpha.com and the subsequent FundQuest white paper ‘What Now – Active or Passive Management? Examining Real Alpha and Exotic Beta’ two questions arise:

    1. What about risk?
    Active management entails taking on more risk, simply by taking a smaller and active sample from a broad based index. Why are the returns in the study not corrected for this risk?

    2. What is the return distribution difference of active vs. passive management?
    Because (portfolio / fund) risk changes going from passive to active management, is it save to assume that the risk profile also changes? This would be a welcome addition to the research.

    Thank you for your attention.

    Kind Regards,

    Michael W.A. Kaal, CAIA
    Directeur AFS Capital Management

  2. Rene Levesque
    February 19, 2010 at 5:53 pm

    To answer to the question “What about risk?” and the perception that active management adds to risk.

    Active trading does not necessarily involve incremental risk. I some cases, it does in fact involve avoiding risks, such as:

    – reducing positions as trends become over-extended, and as “gap risk” is increasing incrementally
    – monetizing gains (in part or whole) and moving on to the next idea
    – reducing overnight exposures, and thus greatly reducing gap risk (when it exist the most)
    – reducing broad (gross) portfolio exposures as market volatility is increased

    These are examples or “active” risk-reducing actions that are applicable in both traditional and absolute return environments.

    The implementation of passive and static positions and waiting for the market to realize that you are right does in fact increase risk, no matter how compelling they are.

    Rene Levesque

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